France and the UK Could Be the Lynchpins of Europe

Over the past two months, Europe’s problems seem to have disappeared from the headlines. However, the new French Socialist government is pushing ahead with policies that favor significantly higher government spending, greater regulation of business and commerce, and severely higher taxes on high earners. The long term effects of these policies, which I believe will lead to further economic decline, may be given fresh scrutiny if France is drawn into a lasting conflict in West Africa as a result of its surprise intervention in Mali last week. The financial discussions that will certainly accompany a longer term strategic commitment to the region may finally make clear that one of Europe’s largest economies is heading down a dangerous fiscal path.

The pressures on France are coming at a time when internal British politics point towards increasing chances that, for the first time, the people of the United Kingdom will be given a referendum vote on their continued membership in the European Union (EU). France is a partner with Germany in the two-nation Axis which effectively runs the EU. Second only to Germany, the UK is a key provider of funding for the EU. If either France faces an economic bailout or the UK votes to leave, the EU likely will begin to disintegrate. Despite massive central bank support, the euro would threaten collapse and cause panic in many markets.

These issues should be looming large on national economies. Instead, investors and the media are focused on some signs of economic recovery in the U.S. Encouraged perhaps by the impact of the Federal Reserve’s unprecedented quantitative easing policies, which have kept interest rates near all-time lows, consumers have spent more freely in recent months. This, possibly combined with government propaganda and misleading statistics particularly regarding inflation and unemployment, has persuaded corporations to spend more. Automobile sales are up and real estate prices appear to be recovering slightly.

This seemingly good news has tabled fears of an imminent crisis. At the same time, and with fantastical schemes like the trillion dollar platinum coin attracting attention, more observers are coming to grip with America’s intractable financial shortfalls. These concerns appear to outweigh ECB president Mario Draghi’s promises to create as much synthetic euro currency as is necessary to support the sovereign debt obligations of all Eurozone member nations. As a result, the euro has staged a remarkable “return to normal” rally, gaining 7.5% against the dollar in the second half of 2012. At present the euro currency is nearing a 10 month high.

Fearing debasement of the U.S. dollar and the Japanese Yen, the euro has become a de facto second reserve currency. Indeed, the fact that the euro exhibited such strength in 2012, when the future of the Eurozone and even that of the EU was threatened, suggests the global insistence that the euro survive. But the situation in France and the UK may test this resolve.

French President Sarkozy was a Europhile. He conducted French policy in lock step support of German initiatives. However, his successor, President FranÃ§ois Hollande, is an ardent Socialist. His policies are leading France towards a possible economic disaster on par with those facing Portugal, Italy, Greece and Spain (PIGS). Intimating that France was a potentially mortal threat to the EU, the Economist’s cover for the November 17th – 23rd 2012 issue carried the headline, ‘The time-bomb at the heart of Europe.’ An open ended commitment to defend France’s former West African colonies against Islamist incursions from the Sahara could fast track a fiscal crisis. Whereas the economies of most of the PIGS were small enough to be bailed out, France has the world’s sixth largest economy. It is far too big for a bailout without threatening the economies of Germany and the UK.

The UK is a major funding source for the EU, second only to Germany. However, despite the fact that the UK is not a member of the Eurozone, the recent Eurozone banking bailouts have involved payments by British citizens via membership of the ECB and the IMF. Naturally this has proved very unpopular. Today, anti-EU feeling is running high. The United Kingdom Independence Party (UKIP) under Nigel Farage, its dynamic leader, now has taken over from the Liberals as the third political party in the UK. Indeed, it looks set to be the first UK party in the next European elections with a platform offering the UK’s withdrawal from the EU.

So while the problems of Europe appear to be contained, under the surface the problems are getting more dire by the day.

John Browne is a Senior Economic Consultant to Euro Pacific Capital. Opinions expressed are those of the writer, and may or may not reflect those held by Euro Pacific Capital, or its CEO, Peter Schiff.